Saturday, November 5, 2011

Roubini On Internal Devaluation

Nouriel Roubini has a very good, very grim new paper on European prospects (no link). I particularly liked this passage:

The international experience of "internal devaluations" is mostly one of failure. Argentina tried the deflation route to a real depreciation and, after three years of an ever-deepening recession/depression, it defaulted and exited its currency board peg. The case of Latvia's "successful" internal devaluation is not a model for the EZ periphery: Output fell by 20% and unemployment surged to 20%; the public debt was—unlike in the EZ periphery—negligible as a percentage of GDP and thus a small amount of official finance—a few billion euros—was enough to backstop the country without the massive balance-sheet effects of deflation; and the willingness of the policy makers to sweat blood and tears to avoid falling into the arms of the "Russian bear" was, for a while, unlimited (as opposed to the EZ periphery's unwillingness to give up altogether its fiscal independence to Germany); and even after devaluation and default was avoided, the current backlash against such draconian adjustment is now very serious and risks undermining such efforts (while, equivalently, the social and political backlash against recessionary austerity is coming to a boil in the EZ periphery).

When all is said and done (and in the European case, that means a lot said but not much done), the euro will stand or fall on the ability of those countries that had rapidly rising costs and prices between 2000 and 2007 to get those costs and prices back in line. At this point the de facto strategy of European leaders is to require that they do this via deflation. And that will not work.